Case Analysis: Correcting Income Statement & Profitability Ratios

Below I have provided a case (Booster Bank) and the part that needs to be focused on is question #3.

Question 3: Assume Dash Spencer, LLP breached the duty of care owed to the Booster Bank. Were damages sustained by the Booster Bank caused by Dash Spencer’s breach of the duty of care? In answering this question do the following: (a) correct the 2018 income statement using the analysis in question 2 above; (b) perform ratio analysis on the four year’s income (as originally stated and then after your corrections in requirement

a) to determine if the firm actually had a pattern of income stability. Calculate standard profitability ratios (Return on Sales, Gross Profit Margin, Earnings per share, plus any other analysis you wish to perform.)

To have this completed you must correct and recreate the journal sheet thats on question 2.

I have provided you with all the files & pdf’s you need to get the assignment done.

Requirements: Complete the question and make it flow with the remainder of the assignment and its other questions. Again this is only just one part to this assignment, so I need about 2 pages of the corrected income statement, ratio analysis, profitability ratios. When you get the numerical analysis part complete, please explain how you got your answer.

To be completely honest I’m having a tough time with this so if you could please just read the whole case and other files provided and see if you can understand for yourself.

BOOSTER BANK
Monday, May 13, 2019, 11:07 a.m.:
“Congratulations are in order! You remember that I told you last year that we would be submitting your
opinion about Circuit Board Framework (CBF)’s financial statements to a bank to get some financing for
our planned addition of a production facility. Don’t you? Well, Booster Bank just notified me that the loan
committee approved our three million dollars loan after analyzing this year’s audited financial statements.
The committee was really impressed that while everyone else in our industry operated at a loss or just
broke even, we showed a substantial profit this period,” crowed Ryan Walker, CFO of CBF, in a
telephone call to Logan Wright, an auditing manager at Dash Spencer, LLP. Logan headed the audit
team that issued an unqualified opinion on CBF’s financial statements for each of the last four years.
“That’s great!” Logan responded. “The loan means that you’ll be able to complete that new circuit board
production facility that you told me about, doesn’t it? That circuit board is the product your budget shows
is going to increase sales revenue and cash flow next year. It’s a good thing you were able to generate a
profit and get the loan. Without the new product, things looked pretty bleak.”
CBF designs and manufactures circuit boards for low-tech applications, such as those used in major
household appliances. Sales in the appliance circuit board industry had declined or been flat in the past
18 months because of people’s reluctance to buy new appliances in a poor economy. CBF’s new circuit
board was for washers and dryers that compete with Maytag’s Neptune series. CBF’s customer (a major
competitor of Maytag) was launching a new washer/dryer with characteristics similar to the Neptune
series, but they expected the price to be about 25% below that charged by Maytag. CBF had developed a
circuit board to meet the engineering specifications of the new product but could only land the business if
they had new production facilities.
Jasmine Young, an auditing staff member assigned to one of Logan’s jobs, overheard the conversation
between Logan and Ryan on the speakerphone while sitting in Logan’s office.
“Logan, I didn’t know that the company operated at a profit this year!” exclaimed Jasmine. “During my
fieldwork, I analyzed the monthly income statements through November, and they showed that the
company operated at a loss almost every month! How did they report a substantial profit at year-end?”
Logan replied, “Several years ago they made an investment in the stock of a closely held company that
they thought might be a good strategic alliance. Unfortunately, that opportunity didn’t work out. Until
December 2018, CBF had been holding the investment and hadn’t been receiving any dividends. The
CFO of CBF actively searched for a company to buy the stock, and in December 2018, located a strategic
buyer who took it off their hands at a substantial gain!” Logan continued. “Since CBF frequently buys and
sells stock investments, the gain is a part of their income from continuing operations.”
“Oh, that’s clever!” Jasmine responded. “But if it were such a large transaction, why didn’t they just use
the cash flow from the stock sale to finance the new manufacturing facility?”
“Well,” Logan explained, “the company that CBF sold the stock to, Easy Exchange, is having their own
cash flow problems right now. They couldn’t afford to give CBF cash, so CBF accepted a non-interestbearing note due in 5 years. Although CBF won’t see the cash for five years, since the title to the stock
has passed to the new owners, it can record the gain on the sale.”
Jasmine pondered this information for a few minutes, and then queried, “Why a non-interest-bearing
note? Most companies with a credit rating like Easy Exchange are paying about 15% on loans for
transactions like this one.”
1
“CBF didn’t have any loans against the investment, so they aren’t incurring any interest cost on the stock
or the new note. They figured that there isn’t any need to hurt Easy Exchange’s cash flow when CBF
doesn’t have any interest cost on the investment,” Logan responded.
“Logan, you sure know a lot about this transaction,” teased Jasmine. “You’d think that you had found the
buyer and negotiated the deal.”
“Well, I am pretty excited,” Logan responded. “I worked with the CFO on the transaction, reviewing the
entry in the general journal and its reporting in CBF’s income statement. I may not have arranged the
deal, but I was instrumental in getting out the audited statements just in time. As you know, CBF really
needed some serious cash infusion as soon as possible from some lender to complete a production
facility for that new circuit board.”
“Since I missed all the excitement while I was working on a different client, why don’t you share
the details of the transaction?” demanded Jasmine.
“Well, CBF was carrying the investment at $6,600,000 and sold it to Easy Exchange for $10,000,000. So,
they booked a $3,400,000 gain on the transaction,” Logan confidentially replied.
Jasmine looked troubled and finally confided to Logan, “I’m enrolled in a CPA review course, and last
week we studied long-term receivables and payables. I learned that generally accepted accounting
principles (GAAP) require notes receivable due in more than one year to be carried at their present value.
Wouldn’t that affect the profit you reported?” Logan looked at Jasmine like she was trying to put him on
the spot and icily replied, “I explained that CBF didn’t incur any interest on this investment before the sale,
so present value calculations aren’t necessary! And, yes, the income statement we audited is consistent
with GAAP.”
Circuit Board Framework (CBF)
Income Statements
For the four years ended December 31, 2018
2018
2017
2016
2015
Net Revenues and Gains Expenses and Losses
$30,250,000
$28,930,000
$27,610,000
$22,990,000
Cost of Sales
16,416,000
13,122,000
10,632,600
9,936,000
Gross Profit
13,834,000
15,808,000
16,977,400
13,054,000
Operating Expenses
3,476,000
3,382,500
3,179,000
2,530,000
Other Expenses
5,027,000
4,362,600
3,460,600
2,435,400
Net Income Before Taxes
5,331,000
8,062,900
10,337,800
8,088,600
Taxes
1,119,510
1,693,209
2,170,938
1,698,606
Net Income After Taxes
$4,211,490
$6,369,691
$8,166,862
$6,389,994
Common Shares Outstanding
3,000,000
3,000,000
3,000,000
3,000,000
2
Memo
To:
Nora Lopez, Loan Delinquency Department, Booster Bank.
From:
Juan Parker, Senior Lending Officer, Booster Bank
Date:
January 17, 2022
Re:
Default on CBF’s loan
______________________________________________
__________________________
As I mentioned to you earlier today, I am forwarding to you the CBF’s file. It is now in default on
the three million dollar loan we extended on May 10, 2019. The total amount currently outstanding is
$2,390,000. We were just informed yesterday that CBF has commenced bankruptcy protection under
Chapter 7 of the Bankruptcy Code. As such, the prospects of a full recovery are minimal.
In addition to the loan documents, I am attaching copies of all the financial statements that we
obtained from CBF as part of the loan application, including the one for the year 2018, which we received
from CBF’s CFO on March 2, 2019.
In looking back at the financial statements that we had in our file, I was stunned by CBF’s
dramatic and sudden collapse. When we approved the loan, the loan committee gave a lot of weight not
only to the financial statements from 2018 but also to the ones from the prior three years; we were keenly
impressed by the firm’s pattern of income stability during those four calendar years.
I am also attaching a copy of an article I had placed in my file a number of years back. Ever since
reading the article, I have had a lingering suspicion that the story in the article is about CBF.
GREEN TIMES
December 13, 2019
boards, had substantially overstated income
and assets in contravention with General
Accepted Accounting Principles. It is really
too bad. I am really looking forward to
joining this new firm. I believe it has a lot of
potential,” said one of the twelve departing
accountants who wished to remain
Glen Oak, Green. In a surprise move
yesterday, twelve staff accountants at Dash
Spencer, LLP left the firm and joined a
competitor, Pillsbury & Skadden. In an
interview with one of the twelve former
auditors, it was learned that the departure
followed alleged auditing irregularities
practiced by senior partners at Dash
Spencer, LLP. “I have been really
disillusioned with the level of scrutiny the
senior managers and partners have been
employing with regard to a number of audit
engagements. In one case that I have
worked on while I was an intern, my former
manager signed off on an unqualified audit
opinion where the client, a designer and
manufacturer of home appliance circuit
3
Required:
Assume that you are Ms. Lopez, an associate in the Loan Delinquency Department at the Booster Bank.
Your supervisor would like to find out from you whether Booster Bank has a claim of negligence against
the accounting firm of Dash Spencer, LLP.
You have gathered additional information from the bankruptcy courts and know about the 2018 sale of
stock to Easy Exchange and its accounting treatment in the income statement. Read the legal cases
collected by the legal assistant and attached in the Library. Assume that the applicable precedent is from
the fictional jurisdiction of the state of Green provided to you in the attached library. Assume that the
financial statements audited by Dash Spencer for the calendar years of 2017, 2016, and 2015 were
accurate.
Prepare a report (see guidelines on the class website) for your supervisor.
You may want to review section 53.01 of the AICPA Code of Professional Ethics (you can review the
section in the case library.) In preparing your answers, you may also wish to review the following Lower
Division Core concepts, described in the Lower Division Core section of the BUS 302L website: financial
accounting concepts 4, 7, and 9, and business law concept 2.
4
BOOSTER BANK LIBRARY
1.
APB Opinion 21
2.
AICPA Code of Professional Conduct, Section 53 – Article II: The Public Interest
3.
Bily v. Peat Young & Company
4.
Manhattan Federal v. Coopers Gibson
5
APB Opinion 21, (portions bolded to direct reader)
12. Note exchanged for property, goods, or service. When a note is exchanged for property, goods, or
service in a bargained transaction entered into at arm’s length, there should be a general presumption that
the rate of interest stipulated by the parties to the transaction represents fair and adequate compensation
to the supplier for the use of the related funds. That presumption, however, must not permit the form of the
transaction to prevail over its economic substance and thus would not apply if (1) interest is not stated, or
(2) the stated interest rate is unreasonable (paragraphs 13 and 14) or (3) the stated face amount of the
note is materially different from the current cash sales price for the same or similar items or from the market
value of the note at the date of the transaction. In these circumstances, the note, the sales price, and the
cost of the property, goods, or service exchanged for the note should be recorded at the fair value of the
property, goods, or services or at an amount that reasonably approximates the market value of the note,
whichever is the more clearly determinable. That amount may or may not be the same as its face amount,
and any resulting discount or premium should be accounted for as an element of interest over the life of the
note (paragraph 15). In the absence of established exchange prices for the related property, goods,
or service or evidence of the market value of the note (paragraph 9), the present value of a note that
stipulates either no interest or a rate of interest that is clearly unreasonable should be determined
by discounting all future payments on the notes using an imputed rate of interest as described in
paragraphs 13 and 14. This determination should be made at the time the note is issued, assumed, or
acquired; any subsequent changes in prevailing interest rates should be ignored.
13. Determining an appropriate interest rate. The variety of transactions encountered precludes any
specific interest rate from being applicable in all circumstances. However, some general guides may be
stated. The choice of a rate may be affected by the credit standing of the issuer, restrictive covenants, the
collateral, payment and other terms pertaining to the debt, and, if appropriate, the tax consequences to the
buyer and seller. The prevailing rates for similar instruments of issuers with similar credit ratings
will normally help determine the appropriate interest rate for determining the present value of a
specific note at its date of issuance. In any event, the rate used for valuation purposes will normally be
at least equal to the rate at which the debtor can obtain financing of a similar nature from other sources at
the date of the transaction. The objective is to approximate the rate which would have resulted if an
independent borrower and an independent lender had negotiated a similar transaction under comparable
terms and conditions with the option to pay the cash price upon purchase or to give a note for the amount
of the purchase which bears the prevailing rate of interest to maturity.
14. The selection of a rate may be affected by many considerations. For instance, where applicable, the
choice of a rate may be influenced by (a) an approximation of the prevailing market rates for the source of
credit that would provide a market for sale or assignment of the note; (b) the prime or higher rate for notes
which are discounted with banks, giving due weight to the credit standing of the maker; (c) published market
rates for similar quality bonds; (d) current rates for debentures with substantially identical terms and risks
that are traded in open markets; and (e) the current rate charged by investors for first or second mortgage
loans on similar property. i7
APB21, Footnote 7–A theory has been advanced which states that no imputation of interest is necessary if the stated interest
rate on a note receivable exceeds the interest cost on the borrowed funds used to finance such notes. The Board
considers this theory unacceptable for reasons discussed in this Opinion.
1
Copyright 2000 Financial Accounting Standards Board (source of GAAP)
6
AICPA Code of Professional Conduct
Section 53 – Article II: The Public Interest
Members should accept the obligation to act in a way that will serve the public interest, honor the public
trust, and demonstrate commitment to professionalism.
.01 A distinguishing mark of a profession is acceptance of its responsibility to the public. The accounting
profession’s public consists of clients, credit grantors, governments, employers, investors, the business
and financial community, and others who rely on the objectivity and integrity of certified public
accountants to maintain the orderly functioning of commerce. This reliance imposes a public interest
responsibility on certified public accountants. The public interest is defined as the collective well-being of
the community of people and institutions the profession serves.
.02 In discharging their professional responsibilities, members may encounter conflicting pressures from
among each of those groups. In resolving those conflicts, members should act with integrity, guided by the
precept that when members fulfill their responsibility to the public, clients’ and employers’ interests are best
served.
.03 Those who rely on certified public accountants expect them to discharge their responsibilities with
integrity, objectivity, due professional care, and a genuine interest in serving the public. They are
expected to provide quality services, enter into fee arrangements, and offer a range of services—all in a
manner that demonstrates a level of professionalism consistent with these Principles of the Code of
Professional Conduct.
.04 All who accept membership in the American Institute of Certified Public Accountants commit
themselves to honor the public trust. In return for the faith that the public reposes in them, members
should seek continually to demonstrate their dedication to professional excellence.
©2000 AICPA
7
CURTIS W. BILY, et al Plaintiffs and
Respondents, v. PEAT YOUNG & COMPANY,
Defendant and Appellant.
Plaintiffs, in this case, were investors in the
Company. They include individuals as well as
pension and venture capital investment funds.
Several plaintiffs purchased warrants from the
Company as part of the warrant transaction.
Others purchased the common stock of the
Company during early 1983.
No. YU56823
SUPREME COURT OF GREEN
The Company retained defendant Peat Young
& Company (“Peat Young”), one of the then-“Big
Eight” public accounting firms, to perform audits
and issue audit reports on its 1981 and 1982
financial statements. In its role as auditor, Peat
Young’s responsibility was to review the annual
financial statements prepared by the Company’s
in-house accounting department, examine the
books and records of the Company, and issue
an audit opinion on the financial statements.
August 27, 1991, Decided
COUNSEL:
Marie L. Fiala, for Defendant and
Appellant. Thomas G. Redmon & Matthew W.
Powell on behalf of Defendant and Appellant.
OPINIONBY: WOODS, C. J.
Peat Young issued unqualified or “clean” audit
opinions on the Company’s 1981 and 1982
financial statements.
OPINION:
I. Summary of Facts
Each opinion appeared on Peat Young’s
letterhead, was addressed to the Company, and
stated in essence: (1) Peat Young had
performed an examination of the accompanying
financial statements in accordance with the
accounting profession’s “Generally Accepted
Auditing Standards” (GAAS); (2) the statements
had been prepared in accordance with
“Generally Accepted Accounting Principles”
(GAAP); and (3) the statements “present[ed]
fairly” the Company’s financial position. The
1981 financial statement showed a net operating
loss of approximately $1 million on sales of $6
million. The 1982 financial statements included a
” Consolidated Statement of Operations” which
revealed a modest net operating profit of
$69,000 on sales of more than $68 million.
This litigation emanates from the meteoric rise
and equally rapid demise of Norne Computer
Corporation (the “Company”). Founded in 1980
by entrepreneur Adam Osborne, the Company
manufactured the first portable personal
computer for the mass market. Shipments
began in 1981. By fall 1982, sales of the
Company’s sole product, the Osborne I
computer, had reached $ 10 million per month,
making the Company one of the fastest growing
enterprises in the history of American business.
In late 1982, the Company began planning for
an early 1983 initial public offering of its stock,
engaging three investment banking firms as
underwriters. At the suggestion of the
underwriters, the offering was postponed for
several months, in part because of uncertainties
caused by the Company’s employment of a new
chief executive officer and its plans to introduce
a new computer to replace the Osborne I. In
order to obtain “bridge” financing needed to
meet the Company’s capital requirements until
the offering, the Company issued warrants to
Investors in exchange for direct loans or letters
of credit to secure bank loans to the Company
(the “warrant transaction”). The warrants entitled
their holders to purchase blocks of the
Company’s stock at favorable prices that were
expected to yield a sizable profit if and when the
public offering took place.
Peat Young’s audit opinion on the 1982
financial statements was issued on February 11,
1983. The Peat Young partner in charge of the
audit personally delivered 100 sets of the
professionally printed opinion to the Company.
Plaintiffs testified that their investments were
made in reliance on Peat Young’s unqualified
audit opinion on the Company’s 1982 financial
statements.
As the warrant transaction closed on April 8,
1983, the Company’s financial performance
began to falter. Sales declined sharply because
of manufacturing problems with the Company’s
new “Executive” model computer. When the
8
Executive appeared on the market, sales of the
Osborne I naturally decreased, but were not
being replaced because Executive units could
not be produced fast enough. In June 1983, the
IBM personal computer and IBM- compatible
software became major factors in the small
computer market, further damaging the
Company’s sales. The public offering never
materialized. The Company filed for bankruptcy
on September 13, 1983. Plaintiffs ultimately lost
their investments.
The case was tried to a jury for 13 weeks. At
the close of the evidence and arguments, the
jury returned a verdict in the plaintiffs’ favor
based on professional negligence. No
comparative negligence on the plaintiffs’ part
was found. The jury awarded compensatory
damages of approximately $4.3 million,
representing approximately 75 percent of each
investment made by plaintiffs. The Court of
Appeal affirmed the resulting judgment in
plaintiffs’ favor with respect to all matters
relevant to the issue now before us.
Plaintiffs brought separate lawsuits against Peat
Young in the Santa Maria County Superior
Court. The focus of plaintiffs’ claims was Peat
Young’s audit and audit opinion of the
Company’s 1982 financial statements. The
theory of liability pursued was negligence.
II. The Audit Function in Public Accounting
Although certified public accountants (CPA’s)
perform a variety of services for their clients,
their primary function, which is the one that most
frequently generates lawsuits against them by
third persons, is financial auditing. “An audit is a
verification of the financial statements of an
entity through an examination of the underlying
accounting records and supporting evidence.”
(Hagen, supra, 13 J. Contemp. Law at p. 66.) “In
an audit engagement, an accountant reviews
financial statements prepared by a client and
issues an opinion stating whether such
statements fairly represent the financial status of
the audited entity.” (Siliciano, supra, 86
Mich.L.Rev. at p. 1931.)
Plaintiffs’ principal expert witness, William J.
Baedecker, reviewed the 1982 audit and offered
a critique identifying more than 40 deficiencies in
Peat Young’s performance amounting, in
Baedecker’s view, to gross professional
negligence. In his opinion, Peat Young did not
perform its examination in accordance with
GAAS. He found the liabilities on the Company’s
financial statements to have been understated
by approximately $3 million. As a result, the
Company’s supposed $69,000 operating profit
was, in his view, a loss of more than $3 million.
He also determined that Peat Young had
discovered material weaknesses in the
Company’s accounting controls, but failed to
report its discovery to management.
In a typical audit, a CPA firm may verify the
existence of tangible assets, observe business
activities, and confirm account balances and
mathematical computations. It might also
examine sample transactions or records to
ascertain the accuracy of the client Company’s
financial and accounting systems. For example,
auditors often select transactions recorded in the
Company’s books to determine whether the
recorded entries are supported by underlying
data (vouching). Or, approaching the problem
from the opposite perspective, an auditor might
choose particular items of data to trace through
the client’s accounting and bookkeeping process
to determine whether the data have been
properly recorded and accounted for (tracing).
(Hagen, supra, 13 J. Contemp. Law at pp. 6667).
Although most of Baedecker’s criticisms
involved matters of oversight or nonfeasance,
e.g., failures to detect weaknesses in the
Company’s accounting procedures and systems,
he also charged that Peat Young had actually
discovered deviations from GAAP, but failed to
disclose them as qualifications or corrections to
its audit report. For example, by January 1983, a
senior auditor with Peat Young identified $1.3
million in unrecorded liabilities including failures
to account for customer rebates, returns of
products, etc. Although the auditor
recommended that a letter be sent to the
Company’s board of directors disclosing material
weaknesses in the Company’s internal
accounting controls, his superiors at Peat Young
did not adopt the recommendation; no
weaknesses were disclosed. Peat Young
rendered its unqualified opinion on the 1982
statements a month later.
For practical reasons of time and cost, an audit
rarely, if ever, examines every accounting
transaction in the records of a business. The
end product of an audit is the audit report or
opinion. The report is generally expressed in a
9
letter addressed to the client. The body of the
report refers to the specific client-prepared
financial statements which are attached. In the
case of the so-called “unqualified report” (of
which Peat Young’s report on the Company’s
1982 financial statement is an example), two
paragraphs are relatively standard.
commentator summarizes: “In the first instance,
this unqualified opinion serves as an assurance
to the client that its own perception of its
financial health is valid and that its accounting
systems are reliable. The audit, however,
frequently plays a second major role: it assists
the client in convincing third parties that it is safe
to extend credit or invest in the client.” (Siliciano,
supra, at p. 1932.)
In a scope paragraph, the CPA firm asserts that
it has examined the accompanying financial
statements in accordance with GAAS. GAAS are
promulgated by the American Institute of
Certified Public Accountants (AICPA), a national
professional organization of CPA’s, whose
membership is open to persons holding certified
public accountant certificates issued by state
boards of accountancy. (Hagen, supra, 13 J.
Contemp. Law at pp. 72-73.)
III. Prima Facie Case for Negligence
A.
Negligence in general: “[N]egligence is
conduct which falls below the standard
established by law for the protection of others.”
(Rest.2d Torts, § 282.) “Every one is [*397]
responsible, not only for the result of his willful
acts, but also for an injury occasioned to another
by his want of ordinary care or skill in the
management of his property or person, except
so far as the latter has, willfully or by want of
ordinary care, brought the injury upon himself.”
(§ 1714, subd. (a).)
In an opinion paragraph, the audit report
generally states the CPA firm’s opinion that the
audited financial statements, taken as a whole,
are in conformity with GAAP and present fairly in
all material respects the financial position,
results of operations, and changes in the
financial position of the client in the relevant
periods.
A. Duty of care: The threshold element of a
cause of action for negligence is the existence of
a duty to use due care toward an interest of
another that enjoys legal protection against
unintentional invasion. (Rest.2d Torts, § 281).
“Courts, however, have invoked the concept of
duty to limit generally ‘the otherwise potentially
infinite liability which would follow from every
negligent act ….’ ” ( Thompson v. County of
Alameda (1980).
The GAAP are an amalgam of statements
issued by the AICPA through the successive
groups it has established to promulgate
accounting principles: the Committee on
Accounting Procedure, the Accounting
Principles Board, and the Financial Accounting
Standards Board. Like GAAS, GAAP includes
broad statements of accounting principles
amounting to aspirational norms as well as more
specific guidelines and illustrations.
The complex nature of the audit function and
its economic implications has resulted in
different approaches to the question of whether
CPA auditors owe a duty of care to third parties
who read and rely on audit reports. Presently,
there are three schools of thought on the matter.
A number of jurisdictions follow the lead of Chief
Judge Cardozo’s 1931 opinion for the New York
Court of Appeals in Ultramares, supra, at p. 441,
by denying recovery to third parties for auditor
negligence in the absence of privity. From the
cases cited by the parties, it appears at least
nine states purport to follow privity or near privity
rules restricting the liability of auditors to parties
with whom they have a contractual relationship.
However, most jurisdictions have abandoned
this restrictive standard because it does not
impose upon accountants a duty commensurate
with the significance of their role in current
business and financial affairs.
Peat Young correctly observes that clients may
commission audits for different purposes.
Nonetheless, audits of financial statements and
the resulting audit reports are very frequently (if
not almost universally) used by businesses to
establish the financial credibility of their
enterprises in the perceptions of outside persons
(e.g., existing and prospective investors,
financial institutions, and others who extend
credit to an enterprise or make risk-oriented
decisions based on its economic viability). The
unqualified audit report of a CPA firm,
particularly one of the “Big Five,” is often an
admission ticket to venture capital markets–a
necessary condition precedent to attracting the
kind and level of outside funds essential to the
client’s financial growth and survival. As one
10
In contrast, a handful of jurisdictions, spurred by
law review commentary, have recently allowed
recovery based on auditor negligence to third
parties whose reliance on the audit report was
“foreseeable.” Arguing that accountants should
be subject to liability to third persons on the
same basis as other tortfeasors, Justice Howard
Wiener advocated rejection of the rule of
Ultramares in a 1983 law review article. In its
place, he proposed a rule-based on
foreseeability of injury to third persons.
that one who negligently supplies false
information “for the guidance of others
in their business transactions” is liable for
economic loss suffered by the recipients in
justifiable reliance on the information. (Id., subd.
(1).) But the liability created by the general
principle is expressly limited to loss suffered:
“(a) [B]y the person or one of a limited group of
persons for whose benefit and guidance he
intends to supply the information or knows that
the recipient intends to supply it; and (b) through
reliance upon it in a transaction that he intends
the information to influence or knows that the
recipient so intends.” (Id., subd. (2).) To
paraphrase, under the restatement view, the
accountants retain control over their liability
exposure. The restricted group includes third
parties whom the accountants intend to
influence or those whom the accountants know
their clients intend to influence. Accordingly,
liability is fixed by the accountants’ particular
knowledge at the moment the audit is published,
not by the foreseeable path of harm envisioned
by jurists years following an unfortunate
business decision. Accordingly, the Restatement
adopts the cautious position that an accountant
may be liable to a third party with whom the
accountant is not in privity, but not every
reasonably foreseeable consumer of financial
information may recover.
Criticizing what he called the “anachronistic
protection” given to accountants by the
traditional rules limiting third person liability, he
concluded: “Accountant liability based on
foreseeable injury would serve the dual
functions of compensation for injury and
deterrence of negligent conduct. Moreover, it is
a just and rational judicial policy that the same
criteria govern the imposition of negligence
liability, regardless of the context in which it
arises. The accountant, the investor, and the
general public will in the long run benefit when
the liability of the of the certified public
accountant for negligence is measured by the
foreseeability standard.” ( at p. 260.) From a
public policy standpoint, the courts that have
adopted the foreseeability test have emphasized
the potential deterrent effect of a liabilityimposing rule on the conduct and cost of audits:
“The imposition of a duty to foreseeable users
may cause accounting firms to engage in more
thorough reviews. This might entail setting up
stricter standards and applying closer
supervision, which should tend to reduce the
number of instances in which liability would
ensue. Much of the additional cost incurred
either because of more thorough auditing review
or increased insurance premiums would be
borne by the business entity and its stockholders
or its customers.” ( Rosenblum v. Adler, supra,
at p. 152.) In the nearly 10 years since it was
formally proposed, the foreseeability approach
has not attracted a substantial following.
For example, the auditor may be held liable to a
third party lender if the auditor is informed by the
client that the audit will be used to obtain a
$50,000 loan, even if the specific lender remains
unnamed or the client names one lender and
then borrows from another. (Com. (h), illus. 6,7.)
However, there is no liability where the auditor
agrees to conduct the audit with the express
understanding the report will be transmitted only
to a specified bank and it is then transmitted to
other lenders. (Com. (h), illus. 5.)
Under the Restatement rule, an auditor retained
to conduct an annual audit and to furnish an
opinion for no particular purpose generally
undertakes no duty to third parties. Such an
auditor is not informed “of any intended use of
the financial statements; but … knows that the
financial statements, accompanied by an
auditor’s opinion, are customarily used in a wide
variety of financial transactions by the [client]
corporation and that they may be relied upon by
lenders, investors, shareholders, creditors,
Most jurisdictions have steered a middle course
based in varying degrees on Restatement
Second of Torts section 552, which generally
imposes liability on suppliers of commercial
information to third persons who are intended
beneficiaries of the information. Section 552 of
the Restatement Second of Torts covers
“Information Negligently Supplied for the
Guidance of Others.” It states a general principle
11
purchasers and the like, in numerous possible
kinds of transactions.
plaintiff must demonstrate that but for the
defendant’s negligence, the plaintiff would not
have sustained the loss. Here, all plaintiffs have
testified that they have read and relied on the
1982 audited financial statement of the
Company before investing their money in it.
Therefore, but for Peat Young’s negligence in
rendering the audit, the plaintiffs would not have
invested in the firm. The plaintiffs would not
have invested in the firm because a financial
statement prepared according to GAAP would
have disclosed the significant liabilities the firm
had at the time. As the plaintiffs were investing
in the firm based on negligently rendered
financial statements that failed to disclose
significant liabilities, they would not have
sustained their investment losses but for the
defendant’s negligence.
In attempting to ascertain the presence of an
intent to benefit third parties from the facts of
particular audit engagements and
communications with auditors, the Restatement
rule inevitably results in some degree of
uncertainty.
Viewing the problem before us, we decline to
permit all merely foreseeable third party users of
audit reports to sue the auditor on a theory of
negligence and we reject the privity relationship
approach as it is too restrictive. Instead, we
follow the majority rule use of the Restatement
approach. Accordingly, we find that since Peat
Young was told that the audited financial
statements would be used to solicit funds from
prospective investors as part of its public
offering and since the plaintiffs here were
exactly such investors, Peat Young owed them a
duty of care.
D. Damages: Lastly, the plaintiff must
demonstrate that she sustained actual loss or
damage resulting from the professional
negligence. Here, following the demise of the
Company, the plaintiffs-investors have lost all of
their investment in the Company arising out of
the warrant transaction and hence they have all
sustained damages.
B. Breach of duty of care: To prove professional
negligence, a plaintiff is required to show not
only that the accountant owed him a duty of
care, but also that he had breached its duty of
care to the plaintiff. In performing professional
services for a client, the independent auditor,
has the duty to have that degree of learning and
skill ordinarily possessed by a reputable certified
public accountant practicing in the same or a
similar locality and under similar circumstances.
In determining whether the accountant fulfilled
its professional duties, one may consider among
other evidence whether or not the accountant’s
work complied with … GAAP and GAAS.
The judgment is affirmed.
Here, the jury had ample evidence to conclude
that Peat & Young breached its duty of care to
the plaintiffs. According to some expert
testimony provided during trial, Peat Young
discovered deviations from GAAP, but failed to
disclose them as qualifications to its audit report.
For example, by January 1983, a senior auditor
with Peat Young identified $1.3 million in
unrecorded liabilities. However, the firm did not
disclose the weaknesses and issued an
unqualified opinion a month later.
C. Causation: Third, to prevail, a plaintiff must
demonstrate that there is a causal connection
between the negligent conduct and the resulting
injury. To determine whether the defendant’s
negligence has caused plaintiff’s injuries, the
12
MANHATTAN FEDERAL BANK, Plaintiff and
Appellant, v. COOPERS GIBSON & CO.,
Defendant and Respondent.
Defendant audited the financial statements of
the partnerships and companies annually from
1981-1988 but failed to disclose these practices
in their audit reports and concluded that the
subject “loan portfolio was adequately
collateralized.”
No. CE765445.
COURT OF APPEAL OF STARS,
SECOND APPELLATE DISTRICT, DIVISION
SEVEN.
COUNSEL:
Spitzer obtained loan funds from the plaintiff,
Manhattan Federal Bank who relied upon
defendant’s audit reports.
July 17, 1995, Decided
On March 28, 1989, the City of Los Angeles
and others filed an action “to redress the
practice … of maintaining and operating slum
buildings through a complex set of financial
machinations.” Defendants included not just
slum building owners but those “who have
financed them.” The complaint alleged “[t]he
lender defendants have been aware of the slum
and substandard character of these buildings;
have been aware of the lack of financial
capability of the record owners; have written
loans which would absorb all or virtually all of
the rental flow from the buildings; have made
huge sums from high interest and high ‘points’
on each loan; have assisted frequent property
transfers, often only months apart and often
timed such that the transfer undermined City
Attorney prosecutions of the then existing record
owners…. have effectively operated as the real
beneficial owners of … one or more of the
buildings ….”
Robert W. Brull for Plaintiffs and Appellants.
Janet B. Bennett for Defendant and
Respondent.
OPINIONBY: MARTINEZ
OPINION:
Appellant, Manhattan Federal Bank, sued
Spitzer Loan Ltd.’s former accounting firm,
Coopers Gibson & Co. for professional
negligence. The accounting firm (defendant and
respondent) demurred, asserting the statute of
limitations. (Code Civ. Proc., § 339, subd. (1).)
The trial court sustained the demurrer without
leave to amend. We affirm.
FACTUAL BACKGROUND
The lawsuit named 141 defendants including
Spitzer Loan Ltd. Of the 11 slum properties
identified in the City lawsuit Spitzer Loan Ltd
financed all.
Spitzer Loan Ltd. (“Spitzer”), a partnership, was
an “alternative lender” company which made
loans to those “who might not qualify for loans
made by most banks or savings and loan
associations.” The loans were “secured by
junior interests in real property.”
Immediately following the filing of the City’s
lawsuit, Manhattan Federal Bank refused to
extend any further credit to Spitzer Loan Ltd.
On November 24, 1989, Spitzer Loan Ltd. filed a
petition under Chapter 11 of the United States
Bankruptcy Code.
Spitzer engaged in the following practices: it
made “uncollectable” loans; it had inadequate
loan loss reserves, it made loans “unjustified by
appropriate lending criteria”; it “rolled over”
defaulted loans into new loans to related parties
and reported defaulted interest and loan fees as
income; it used interest reserves to make new
loans; it made loans secured by property which
they had appraised only by a “drive-by” without
inspecting the interior and “based upon
dissimilar and/or incomplete market analysis
data.”
On October 15, 1993, appellant filed the instant
action for professional negligence, breach of
written contract, and negligent
misrepresentation.
On February 17, 1994, respondent demurred to
the complaint. On May 24, 1994, after a hearing
and argument by counsel, the trial court
dismissed the complaint without leave to amend,
stating the two year statute of limitations barred
the professional negligence cause of action
13
because “[t]he City’s suit provided sufficient
notice to start the statute of limitations running.”
alone a professional lender, to the almost
worthlessness of the properties. For example:
“These slum dwellings … have rodent and
vermin infestation, lack of hot water and heat,
severe fire hazards, undisposed of garbage and
other unsanitary conditions, broken windows
and doors, leakage from plumbing and roof
defects, [and] a serious lack of personal security
and similar conditions.”
On June 17, 1994, the trial court signed an
order dismissing the lawsuit. This appeal
followed.
DISCUSSION
“[I]n a malpractice action against an accountant
the statute of limitations does not run until the
negligent act is discovered, or with reasonable
diligence could have been discovered.” ( Moonie
v. Lynch (1967); Liberty Mut. Ins. Co. v. Harris,
Kerr, Forster & Co. (1970) “The ‘discovery rule’
assumes that all conditions of accrual of the
action—including harm–exist, but nevertheless
postpones commencement of the limitation
period until ‘the plaintiff discovers or should have
discovered all facts essential to his cause of
action, which is to say when plaintiff either (1)
actually discovered his injury and its negligent
cause or (2) could have discovered injury and
cause through the exercise of reasonable
diligence. CAMSI IV v. Hunter Technology
Corp. (1991)
As to appellants’ eleven involved properties, the
City lawsuit complaint stated among other
things: the 2686 Idell Street property “has been
in substandard condition since 1982 or earlier”;
the 5634 North San Pedro property “has been a
slum since 1981 … and [s]ince 1979 … has been
cited 18 times for violations of the fire codes,
health codes and building codes”; the 9632
Virginia Lane property “was cited for numerous
housing code violations since at least 1981. The
7342 North Bonnie Brae Street property “has
been a slum building, unfit for human habitation,
since before 1981. The property has been the
subject of six criminal prosecutions … in the
period 1981 to 1988 ….”.
Finally, these City lawsuit allegations,
irreconcilable with respondent’s audits, should
have led appellants to discover “all facts
essential to [their] cause of action” against
respondent back in 1989 ( CAMSI IV v. Hunter
Technology Corp., supra, at 1526): “Acting
fraudulently, the lender defendants, with full
knowledge of the slum character of these
buildings have made loans for amounts
exceeding the value of the slum buildings ….”;
“The slum buildings …, at material times … have
had no reasonable rental value”; “… the loans
made by the lender defendants were
unjustifiably high in that they were clearly
unwarranted by the value of the slum building”;
“… The loans were made … without any or with
completely inadequate appraisals of the
property; lending without any or with completely
inadequate credit checks of the borrowers”; “The
lender defendants routinely and repeatedly
made loans to record owners in amounts that
were far in excess of the true value of the slum
buildings.
Appellant contends that while it had possession
and its officers have read the city’s lawsuit in
1989, it could not with reasonable diligence have
discovered respondent’s negligence from the
city’s lawsuit for all of the following reasons: (1)
that lawsuit involved only eleven of Spitzer Loan
Ltd.’s properties out of a loan portfolio secured
by hundreds of properties (2) “the City Lawsuit
did not name [respondent], did not contain any
reference to [respondent] or [respondent’s]
audits, or otherwise give notice that [respondent]
failed to perform its audits in accordance with
GAAP [Generally Accepted Accounting
Principles] or committed any wrongdoing.” (3)
“nothing in the City Lawsuit suggested that the
financial condition of Spitzer Loan Ltd. Was
materially misstated in their financial statements”
and (4) respondent issued an audit report after
the City lawsuit filing which indicated “Spitzer
Loan Ltd. had a substantial net worth, its
accounting procedures wholly complied with
GAAP and their loan loss reserves were
adequate.” The contention does not bear
scrutiny.
In addition, lender defendants repeatedly
inflated the alleged value of the slum buildings
despite the steady deterioration of the
properties.”
The 134-page City lawsuit complaint described
the subject slum properties. Those descriptions
would have alerted any reasonable person, let
14
DISPOSITION
The two-year statute of limitation has began running in 1989 when the appellant either had actual
knowledge or should have discovered through the exercise of reasonable diligence the respondent’s
alleged negligence. Since the appellant waited until 1993 to file this action for professional negligence, it
is time barred under
the two-year statute of limitation. The judgment is affirmed. Costs on appeal are awarded to respondent.
Lillie, P. J., and Johnson, J., concurred.
______________________________________
15
BOOSTER BANK – QUESTIONS
In preparing a report for your supervisor at Booster Bank, incorporate answers to the
questions below.
Q. 1. Did Dash Spencer, LLP owe a duty of care to the Booster Bank?
Q. 2. Assuming Dash Spencer LLP owed a duty of care to the Booster Bank, did Dash
Spencer, LLP breach that duty of care? In determining whether breach occurred, make
sure to perform the following accounting
analysis:
a. Recreate the journal entry that Circuit Board Framework (CBF) made when it sold the
stock to Easy Exchange. How much gain was recognized on the sale of the stock? How
much cash inflow did this transaction create for CBF?
b. Calculate the present value of the note receivable using a 15% interest rate. Using the
present value of the note as the only economic benefit received, recalculate the gain or
loss on the transaction.
Q. 3. Assume Dash Spencer, LLP breached the duty of care owed to the Booster Bank.
Were damages sustained by the Booster Bank caused by Dash Spencer’s breach of the
duty of care? In answering this question do the following: (a) correct the 2018 income
statement using the analysis in question 2 above; (b) perform ratio analysis on the four
year’s
income (as originally stated and then after your corrections in requirement
a) to determine if the firm actually had a pattern of income stability. Calculate standard
profitability ratios (Return on Sales, Gross Profit Margin, Earnings per share, plus any
other analysis you wish to perform.)
Q. 4. In this case, there were many people who had to deal with ethical issues. Analyze
the issues faced by Logan Wright, Ryan Walker, and Jasmine Young, and indicate the
following for each:
a. Were their actions ethical? In each case indicate which principle or test of ethics you
are applying to determine your answer.
b. Indicate whether you think their actions were justified or not given the
circumstances they were faced with. “You may want to review section 53.01 of the
AICPA Code of Professional Ethics. (You can review the section in the case library.)”
Q. 5. Analyze this case using a strategic perspective. In your answer cover the following:
Coaching notes
● No money changed hands
● Booster Bank has a claim of negligence against the accounting firm of Dash Spencer,
● Whats being evaluated : whether there is a claim of negligence against accounting firm
● Four elements: duty, breach, actual, and approximate
○ Duty(owed to group of foreseeable parties, acting w/ care): spencer to bank
■ To whom is that duty owed?
■ Whether there’s a duty on accounting firm extended to bank, see if the
harm is foreseeable, Restatement view.
■ Accounting knew statements would be used to get loan
■ Did bank have contract with accounting firm?: accounting firm hired and
had contract with manufacturer, no direct link to accounting firm to bank,
■ Restatement of torts: lending and equity participants
■ Duty to account firm and booster bank
■ Rely on accounting notes in library, opinion 21 and code of professional
conduct
■ Stock worthless bc accounts allowed clients to overstate value
○
● Misrepresentation of income, but for the accountants conduct this wouldn’t have
happened (but for test)
■ Damages 2.39million
● Recommendation and considerations directed to bank
● Lawsuit outside statute of limitations: last case in library (wouldn’t be in case if not
important, dates are important, loan early 2018, memo 2022) two year statute of
limitations where you should’ve known there was negligence, bank claims they didn’t
know until they went bankrupt but article shows they should’ve known in 2019